Liquidity Issues Constrain Amazon's Growth

Amazon.com (NASDAQ:AMZN) never raises prices. Jeff Bezos must have had a gun to his head when he agreed to even consider a price hike of 25 to 50% on Amazon Prime membership. This gun was not from investors who continue to believe in the Amazon story - the stock hit an all-time high just days before the conference call. The threat is different, more imminent and dangerous: Amazon is running out of money.

Growing companies need more capital. They issue stocks or borrow money. Profitable companies also reinvest their earnings to support their expansion. How did Amazon, never consistently profitable, manage to grow so fast for so long?

Over the past 15 years Amazon retained $2.2 billion in earnings and raised $7.6 billion by issuing new stocks. Suppliers, however, provided much more capital than investors, extending $15.1 billion in credit to the company in its most recent quarter, or 38% of its balance sheet compared to 24% for total shareholders equity. (These and other numbers in this article come from the latest SEC report filed by Amazon).

Most companies have to pay their bills first, and collect money from their customers later. Amazon, on the other hand, pays its suppliers, on average, 74 days after they deliver their products to Amazon's warehouses. Since it takes Amazon fewer days to sell their merchandise, it gets to keep the money for awhile.

There is nothing wrong with this picture per se. A profitable company with a negative cash cycle can expand indefinitely. Amazon, however, has four major problems.

First, inventory turnover is steadily slowing down. From 12 times in 2009 it fell to 8.9 times in its most recent quarter. It means that it used to take Amazon 30 days to sell its inventory. Now it takes 41 days. Wal-Mart (NYSE:WMT), by the way, moves its inventory every 34 days, so Amazon is now less efficient than Wal-Mart on this metric. For some time the company was able to kick a proverbial can down the road by paying its suppliers a little later. Apparently, there is a limit to how much suppliers are willing to suffer - accounts payable actually dropped from 76 days a year ago to 74 days. For comparison, Wal-Mart, never known to be a supplier hugger, pays its bills in 46 days.

This slowdown in inventory turnover combined with faster supplier payments and juxtaposed against the slowing revenue growth pressures the company's balance sheet. Currently Amazon has enough unrestricted cash and marketable securities to cover 59 days of expenses, compared to 69 days a year earlier. With the accounts payable stretched to the limit, the company will have to find a different source of capital to support its growth going forward.

The second problem is that Amazon's business is seasonal. A drop in sales in the first quarter creates a cash management challenge: large holiday bills come due while the revenues are light. The company borrowed $3 billion at the end of 2012, which helped it to get through the first quarter of 2013. It continued to borrow throughout the year, increasing its total debt by over $2 billion. This year it has even less wiggle room on its balance sheet, so it may have to borrow again.

Third, the fastest-growing parts of Amazon do not enjoy the same negative cash cycle. For example, the company has to build new data centers and hire people before it can sell its web services. In other words, AWS growth requires real cash. It is still a small unit compared to the rest, but it is becoming increasingly significant with every passing quarter.

Amazon's expenses are growing as fast as its revenues, and most of these expenses cannot be pushed forward to be paid from the future revenues. For example, Amazon hired 28,900 employees in 2013, a 33% increase. Compare it to 5% increase in unrestricted cash and marketable securities, and it becomes obvious that Amazon's financial flexibility is quickly decreasing.

Finally, there is an issue of "other long-term liabilities". They increased by almost $2 billion in 2013. This is a very significant increase in its own right, but this number does not include any commitments related to Prime video. Currently, obligations related to video content stand at $1.1 billion, with at least $539 million payable this year. The company does not show these commitments on its balance sheet.

For comparison, Netflix currently has $7.3 billion in future content obligations that it does not show in its books. Since Amazon competes with Netflix for content, it is reasonable to assume that the content owners seek similar revenue guarantees from both companies. Amazon has experienced a surge in Prime members recently. While Wall Street cheered, the bean counters at Amazon were probably scratching their heads: with "tens of millions" of Prime members the company may be on the hook for a few billion dollars in extra expenses, if it wants to maintain a content library that is comparable to Netflix. This is a lose-lose situation: the company will have to pay up, which it cannot afford, or scale back free content available to Prime members, which won't make them happy. Most Prime members signed up for the shipping privileges, but when you start taking away from your customers, it never goes well, however insignificant the perk was in the first place.

The best hope for Amazon investors at this point is for a soft landing: a smooth transition from the profitless fast growth model to a profitable slow growth path. Most investors believe that Amazon can raise prices at will when the time comes. Well, the time has come. Amazon's debt load increased by over $2 billion in 2013. Its total (including off-balance sheet) commitments have reached $16.4 billion, of which $3.9 billion are due this year, and $3.2 billion in 2015. Unless Amazon plans a new share issue, the company will have to come back to the debt market soon, and it has to shore up its income statement for any hope of favorable terms.

While Amazon's shareholders remain oblivious to its lack of profits, the balance-sheet reality forces the company to modify its business model. Last quarter Amazon raised a threshold for free shipping by 40%. It increased gross margin by 3.3 percentage points. Now it disclosed a plan to raise Prime fees by 25-50%. It remains to be seen if these actions lead to the improvements in its bottom-line, substantial enough to sustain its growth.

I believe that the company is too big and complex, and it may be too late for a soft landing. When a stock trades at a price-earnings ratio of over 500, even a small change in expectations may lead to a major price adjustment. Ultimately, Amazon may be able to transform itself. History - and the outcry of customers against the Prime fee hike - suggest, however, that the transition is going to be bumpy, and the success is far from being guaranteed.

Disclosure: I am short AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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